Non-monetary criteria for economic performance
Over the past four years, we have learned that the crisis has many faces. It all began in the United States, where real estate prices suffered a massive collapse in 2008. Today, we are focused on a crisis of the common European currency. When Nobel Laureates and economists met in August 2008 in Lindau on Lake Constance to evaluate the unfolding economic threat, it already seemed apparent that much of traditional economic theory would have to be reconsidered. For example, the Nobel laureate Joseph Stiglitz predicted that a number of economic theories would not survive the crisis. Berkeley professor Daniel Mc- Fadden even went so far as to declare that the assumption that the financial markets functioned effi ciently was no longer valid. Even as early as 2008, analysts and investors will have wondered how things could have gotten to where they then turned out to be. Why was the majority of economists and market participants so surprised by the enormity of the crisis?
Behavioral economics
Since then, our globalized society has endured multiple phases of economic anxiety. These were punctuated only by the briefest glimmers of hope, and sometimes they culminated in panic and desperation. Chancellor Angela Merkel had to reassure savings account holders in 2008 that their money was safe, while her Foreign Minister Walter Steinmeier demanded, in the bluntest of terms, that greed and recklessness be reined in in the future. A pious wish indeed – after all, the world’s religions and science have pursued the same goal for millennia with little success. While some things have in fact changed over the past few years, economists nonetheless have failed to learn one key lesson from the crisis: they need to finally apply psychological methods to economic theory in order to understand the origin of, and better prevent, economic crises. Instead, economists persist in trying to squeeze their discipline into the corset of natural science. Even if that means going to extraordinary lengths to keep Homo Oeconomicus on life support long after it has been proven that this theoretical model of a purely rational, unemotional actor does not match the reality of the fi nancial markets. Economists in the USA have come a bit further. Over the past 20 years, a branch of economics called “Behavioral Finance” or “Behavioral Economics” has established itself there. This subdiscipline is working towards forming a meaningful and productive union of economic and psychological methods. Even hardened stock market professionals are hardly so cold-blooded and in control that they succeed in constantly maximizing their profi ts, as traditional economic theory assumes they should. Rather, they seek comfort and enjoyment while they make money, like anyone else. Profi t is a fi ne thing, but making a profi t should be fun. That is why in practice they tend to rake in profi ts too quickly while failing to contain losses quickly enough. Being right is also a fi ne thing, and being right often is an even fi ner thing. Thus, it’s no surprise that people will do anything to avoid accepting losses. We are all trying to make decisions that we will not have to regret later on. Scientifi c studies have shown just how low the impact of economic data actually is on fi nancial markets. In truth, this is how the process goes: Investors prefer to perceive and pass on information that reinforces their own actions. In that respect, they are probably acting more rationally than many think. All people – not just those who participate in the fi nancial markets – try to optimize the use of their inherently limited mental capacity in order to come to grips with the constant fl ood of information. With respect to our wellbeing, that means we primarily focus on information that retroactively justifi es decisions we have already made. On the other hand, we try to ignore or downplay the signifi cance of information that might cause us to reconsider our position.
Frame of references
We can see this strategy everywhere we look – in business and in people’s personal lives. As we observe it, yet another assumption of standard economic theory emerges as false. People do not evaluate situations and decisions in absolute terms. That is, they do not think solely of their fi nal balance. Rather, they constantly compare themselves with others. What matters to them is not how much they earned themselves, but whether they earned more or less than others. In other words: Success and failure are always measured relatively – depending on a particular frame of reference. That frame of reference could be the purchase price of a stock or one’s own account balance, but it could also be a neighbor’s car, house, or racing boat. This relative evaluation can extend so far that a loss is perceived as a profi t because it did not turn out as large as expected – or because an acquaintance or a colleague did even worse. And conversely, profi ts can even make us unhappy when they do not live up to expectations.
Reliable predictions
Fear, hope, and desperation, those concepts we always hear in discussions of the psychology of the market, are by no means the main topics of “Behavioral Finance.” Rather, this discipline is focused on recognizing and describing the systems at work behind the disproportionate and irrational behavior of market participants. An understanding of these systems is needed to make reliable predictions about the future decisions of market actors. Whoever succeeds at that will have a considerable advantage over his competitors – in the market as in life.